Causal Relationships Only

Understanding how x causes y
is a must for Dr. James Weston

James Weston arrived home from work one evening and
settled into his routine of grabbing a beer and watching
PBS NewsHour. Before the program started, there was a
20-second commercial sponsored by BASF. He recalled it
went something like this. “We don’t make computers, we
make them lighter; we don’t make bridges, we make them
more durable. We don’t make a lot of things you use, but
we make them better.”

His first reaction — what is this? Why would a company
that does not produce consumer products buy media time
on television to basically say they exist? That commercial
nagged at him until finally, some time later, BASF did a
seasoned equity offering. Now, it was starting to make sense.
BASF was advertising — hey, get familiar with us before
we do a public equity offering. Their media buys were on
PBS and during golf tournaments where viewers were likely
to be educated and affluent, essentially their investor base.
And, Weston thought, “This could be a paper!”

It turned out to be a highly cited paper. Working with Rice
colleagues George Kanatas and Gustavo Grullon, Weston
collected information on thousands of public firms and
their advertising expenditures and examined how it related
to stock market liquidity and security offerings. Their
research showed that firms that are well-known among the
investor base have a much easier time raising public equity.

Got Questions?

The BASF commercial was just one example of
the many questions rolling around inside Weston’s
brain. He’s always mulling a number of them,
and then one will jump out because he finally
has figured out where to find the data to answer
it. Weston takes a natural science approach to
causality. His pet peeve is soft research that is
qualitative and hard to pin down. “You have to
test hypotheses that come from theories and
accept or reject them,” said Weston. “You have
to be scientific about weighing the evidence.”

Along with several Rice colleagues, Weston
challenged some of the earlier work in the area
of behavioral finance and actually got into a war
of papers with a group from Harvard. “They
wrote a paper basically saying that managers
regularly can fool investors, and we challenged
that notion with hard evidence that showed
what they were saying was not true.”
Harvard shot back with a critical paper; the
Rice group responded, and additional written
volleys came from both sides. “It was kind of
fun, and it all got published in the finance
journals,” said Weston. “And I think we put a
lid on their literature.”

Weston’s questions and ideas come from, well,
everywhere. He loves the quirky and runs an
eclectic research program. Consider his workin-
progress on religion and corporate
misbehavior. The behaviors he is measuring are
not illegal, but consist of policies and practices
one would rather not show up in the Wall Street
Journal. It has been a huge project that involves
collecting samples from every public company
for the past 40 years as well as data from the
religious census conducted every ten years.

While Weston is not attempting to make an
association between morality and religion, the
data shows that firms headquartered in counties
ranked higher in religion do exhibit different
behaviors across the board. “Perhaps when
you’re headquartered in rural religious towns,
you feel it’s more likely that you’ll be monitored
and so you’re more controlled in your behavior,”
said Weston. “You’re less likely to make a sneaky
earnings play, adapt some questionable strategy,
or pay your CEO forty times that of the average
worker.”

Taking Stock

A fundamental question in finance that piqued
Weston’s curiosity was, “Why pay dividends?”
Dividends are correlated with many things, but
Weston and his colleagues wanted to pull out
causation. They started looking at companies
on the Russell 1000, the largest public firms in
the U.S., and the Russell 2000, the next 2,000
firms. Each is a value-weighted index, so if you
happen to be 998 on the Russell 1000, you’re
a trivial member of the group. But, say over
the course of a year, you lose a few dollars
of market cap and end up being 1002 on the
Russell 2000. You go from being a grain of sand
to a whale, and every institutional investor
has to own you and benchmark against you.
In the meantime, the firm that got a little
bigger and went from 1001 to 999 becomes the
grain of sand. “These firms didn’t do anything
differently in that narrow range around the
cutoff,” explained Weston. “But there is a huge
movement in institutional ownership, so you
take a nosedive or soaring jump depending on
the threshold.”

What happens when all these institutions pile
into a stock? Do they make the firm pay
dividends, and when they pile out, do dividends
stop? Using the Russell variation to test the
causal effect of dividend policy, Weston found
that, yes; institutions do force firms to pay
dividends.

“We look at a couple of dozen firms above and
below the threshold every year when the Russell
is rebalanced,” said Weston. “Companies don’t
know where they will land. You cannot choose
to be above or below the line. It’s random; and
that’s exactly how I want it to be as a scientist.”

And that attitude is exactly what makes Dr.
Weston’s research so impactful in the world of
finance research.

James P. Weston is a professor of finance at the
Jones School. He joined the faculty in 2000 and
currently teaches the core finance course which
focuses on valuation, corporate finance, and
financial modeling. His research covers a wide
array of corporate finance issues and his articles
have appeared in many of the leading academic
finance publications as well as being cited in the
popular press. He is a former assistant economist
at the Federal Reserve Bank of New York and
holds a Ph.D. and M.A. in economics from the
University of Virginia. He also earned a B.A. in
economics from Trinity College.